1. The market economy relies on the price mechanism at heart. This is the original idea now associated with Adam Smith that an automatic allocation of goods and services will happen in each market when demand and supply are allowed to find their own equilibrium. The price mechanism is held to indicate, or signal, to producers and consumers which market is ‘up’ or ‘down.’ In the system, consumers are believed to seek to maximise their utility, and suppliers are expected to maximise their profits. The price is their incentive to do so, and their decisions inform the allocation of resources by producers.
This system has been held to rest on the ideas of consumer and producer surplus (which are different from the idea of transfer earnings and economic rent, though they could explain it too.) Firms are assumed to seek maximum profit, which is the greatest gap between total costs and total revenue. Since in competitive markets firms have very little to no control over prices and are price-takers, they are therefore encouraged to push down costs to the lowest average cost by maximising efficiency. This push to productive efficiency contributes in turn to the allocative efficiency of the economy, in which waste is in theory reduced or eliminated and goods are sold at or near marginal cost.
Consumers benefit from this system in the sense that they are assumed to have a utility they are aware of, and a price that they will pay to obtain it, in their minds. When the market price is below this price, consumers will continue to buy, having found a bargain, until the price and their utility meet. The consumers also benefit from choice of providers and suppliers. Given that most markets in the real world are not for homogenous but for differentiated products, which are made by producers seeking an advantage, consumers also gain the benefits of innovation and choice.
This theory of the market can be applied to almost all economic goods (though public, merit, and demerit goods with externalities but little chance of proper pricing present real problems.) Markets can also apply to goods and services in derived demand, like labour. A free and fair market, in which there was equal bargaining power between workers and employers and where workers could be paid at the level of their marginal revenue which they brought to a firm would deliver maximum wages and productivity.
There are various conceptual and practical problems with the idea of the market, however. Firstly, the market as conceived by Adam Smith stems from an idea of the moral economy of people. It is assumed that people want to spend energy maximising utility, that consumers and suppliers will be rational, and that markets can be left to a very high degree to the ‘invisible hand’ created by the interaction of consumers and suppliers.
In recent years, economics has however taken a turn into the insights of other social sciences. Many economists now argue, for instance, that rational consumers maximising utility is an abstract ideal. Instead, consumers could be subject to the pressure of a need for immediately satisfying rather than maximising a need; they could behave habitually, have poor computational skills, lack information, or be subject to the influence of the crowd. Advertising and marketing would also serve to alter the elasticity of demand. Demand itself is only ever effective demand too, and the existence and effects of long-term or growing inequality might be sufficient to distort market decisions and to elevate inferior and Giffen goods, as well as ‘Veblen’ goods in conspicuous consumption. These pressures and problems with demand would not lead to a situation where markets become dynamically efficient and allocate resources rationally or consistently.
Most firms are not organised to maximise profits. They are in general profit-satisficing but could also choose to be revenue- or sales- maximising and, in certain short run conditions, might choose to remain in business whilst making a loss that could cover variable cost. They might do this because of the structure of the firm. Public limited companies would be under more pressure to deliver dividends and therefore maximum profits to shareholders at most times, but can also exist in environments in which investment, research and development, and fixed cost such as advertising, marketing, and public relations rise. Markets can be structured in such ways that firms are not encouraged to compete on price, and to maintain barriers to efficiency which fail to allocate resources evenly, such as in oligopoly or natural monopoly. Sole traders very often lack the time or resources to work out how to maximise profits and instead make a satisfactory profit on which they can subsist.
Many markets are more informed by law and social power than they are by utility and rationality. A market could not exist at all without contracts, for instance, and contracts require a system of adjudication and sanction to operate, all of which could limit the freedom of firms to allocate as they wish, or of consumers to make informed choices about utility and purchases. As Gillian Tett has shown in studies of the financial industry, the culture of firms, and the willingness of governments to make strategic interventions in the financial market, very much affect choices for producers and consumers within the market. Labour markets also tend to give rise to monopsonies, which are distorted markets in which the power to set wages and to affect the level of employment sits with firms and not workers. When workers organise a countervailing union, law, regulations, and social attitudes can affect their demands and therefore the supply of labour.
Goods with negative and positive externalities, and the existence of public goods, will also affect the capacity of the market to allocate resources efficiently. A negative externality is a cost to society which is not paid by those who are engaged in the original transaction.
Producers in a pure market economy will have no incentive to allocate resources to producing public goods. This is because they will have not be able to make consumption of the goods dependent on payment. Merit goods will be under-consumed as consumers will not be fully aware of their true benefits and because they do not take into the external benefits created. As a result of the under-consumption, merit goods will be under produced – there will not be enough resources allocated to their production. In contrast, too many resources will be devoted to producing demerit goods. They will be overconsumed as consumers will not be fully aware of their harmful effects and will not take into account the external costs they generate.
Consumers and producers base their consumption and production decisions on private costs and private benefits. The failure to base decisions on social costs and social benefits will result in resource allocation being socially inefficient. It is possible that resource allocation may also be inefficient because of the immobility of factors of production. For instance, if labour is occupationally and/or geographically immobile, there may not be enough workers to make more popular products while there may also be unemployed workers.
A market economy may allocate resources in a way that benefits consumers with high income. Poor consumers, however, will have less influence on what is produced. A market economy has several potential advantages including encouraging entrepreneurship and innovation, but most economists accept the need for some government intervention to correct the market failure that may arise. Where economists disagree is the extent to which the government should intervene.
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